Question 1: Provide a Precise Definition of an Asset Price Bubble

Volume 34, Number 3, February 2017

Answers

Price bubbles and behavioural economics

Jon Guest

This resource provides answers to the questions set in the article on price bubbles,
on pp. 2–5 of the February 2017 issue of Economic Review.

Question 1: Provide a precise definition of an asset price bubble

The following definition is provided in the article:

‘when the price of securities or other assets rise so sharply and at such a sustained rate that they exceed valuations justified by fundamentals, making a sudden collapse likely — at which point the bubble bursts’.

Some other definitions include:

‘If the reason the price is high today is only because investors believe that the selling price will be high tomorrow — when “fundamental” factors do not seem to justify such a price — then a bubble exists.’ Stiglitz (1990)

‘any significant increase in the price of an asset or a security or a commodity that cannot be explained by the fundamentals.’ Kindleberger (2005)

‘an asset whose price rises rapidly, encouraging investors to buy it, even though it is over-valued, because they can turn around and sell it at a higher price than they bought it at.’ Geraskin and Fantazzini (2011)

Question 2: Outline some of the differences between the housing and stock markets

Four differences were identified in the article:

· Liquidity/elasticity — the supply of a share can be increased much more quickly than the supply of housing, e.g. a firm can issue new shares at relatively short notice while it takes a much longer period of time to obtain planning permission build new houses.

· Characteristics of the asset — housing has far more characteristics that influence its selling price (i.e. location and size) than the stock market.

· Measuring market fundamentals — because of the greater variation in the housing market it is far more difficult to make accurate judgements about underlying market value than it is with stock/shares.

· Objectives of the buyers — the majority of people who purchase stocks and shares do so for one reason — to try and maximise the return on their investment through dividends and increasing prices. Some buyers in the housing market will be motivated by the desire to try and maximise the return on their investment while many others will be influenced by the consumption benefits, i.e. having a nice home to live in.

Question 3: Using a demand-and-supply diagram explain how expectations about future prices changes can create a bubble

See the video in the separate resource on EconomicReviewExtras.

Question 4: Explain why it might be rational for some investors to buy an asset even if they believe it is overpriced

Even if an investor believes that a particular asset is overpriced it may still be rational for them to buy it if they believe its price will continue to rise in the future. This anticipated increase in the price must provide a greater return than could be achieved by investing the money in the next best alternative. It could be irrational if the main motivation for buying the asset was simply o mimic the behaviour of other investors in the belief that a large group could not be wrong (i.e. herding behaviour).